September 9 2020

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Exercise 1 The market value of the assets of a company is equal to € 60 million. The company is financed with debt (the market value is equal to € 24 million, the annual cost of debt is equal to 5%). The operating margin of the company (i.e. revenues net of operating costs) is equal to € 6 million each year, on average. The e quity capital is divided in 10 million shares. The tax rate on corporate gross profit is equal to 28%. Determine: 1. the annual net profit (earnings) and the earning per share (EPS); 2. the share market price and the expected profitability kE of the equity capital; 3. the value of the ‘tax shield’, i.e. the present value of the tax savings related to debt financing (list the relevant assumptions to be made); 4. the value of the company, in the case it is financed only with equity (unlevered). The CEO is willing to raise new debt, for a further amount equal to € 19 million (at the same cost, 5%). The capital raised will be invested in new projects, this increasing the expected value of the annual operating margin, to € 8 million. Determine: 5. the new value of the company annual earnings (net profit); 6. the market value of the assets and of the equity capital after the increase in the debt amount; 7. the new value of the equity return; 8. the new market value of the share. Now, assume that the amount of debt X exceeding the total amount of € 30 million determine s costs related to financial distress C, that may be estimated (in present value) equal to C(D) = 0,03 * D2 (C is in € million, number D is equal to the value of X in € million). Find out if the CEO proposal is the best solution to maximize the value of the assets, or if it is better to raise a part of the € 19 million issuing new equity capital (rather than debt). Exercise 2 Financial…